The independence of central banks can now be seen as nothing more than a convenient fiction. If there were any residual doubt, witness the performance of the European Central Bank last week.

The list of actions taken by ECB president Jean-Claude Trichet against his initial wishes is long and growing. Two years ago the idea that the ECB would openly buy government bonds in the secondary market and accept non-investment grade securities as collateral was unthinkable. Last week it could not buy enough of them to stave off the latest round of the eurozone crisis.

This was only the latest act of Trichet the tightrope walker. He has fought hard to maintain an independent line, but has already caved in to political pressure over what is acceptable collateral and has consistently changed and fudged the rules in order to provide liquidity support to the failing PIGS – Portugal, Ireland, Greece and Spain – and now Italy.

His actions have clearly been influenced by the fiscal deterioration in the EU periphery. Who knows what they will have done by the time the euro crisis is over. The ECB balance sheet is fast becoming a repository for all EU government debt. If Germany does not pick up the tab, they will have no option but to monetise it.

The illusion that central bankers set their own agenda no longer fools the audience. The sleight of hand is just not fast enough, although it might have been a good trick while it lasted.

Alan Greenspan was the main protagonist and his “Greenspan Put” consistently supported markets to the benefit of his friends on Wall Street and in Washington. While the fiction held, he was lauded as “The Maestro” but it is now clear the emperor had no clothes.

It is now recognised that there are long-running costs to sustained low interest rates. Growth driven by increasing leverage is not sustainable – indeed, it creates instability. Greenspan is now viewed more as a muppet than a maestro. In short, central banks failed.

But despite their failure to control asset price bubbles, recognise the dangers posed by excessive leverage, or to protect the majority of the population from the fallout of the financial crisis, their independence is still unquestioned. Almost the entire post-mortem analysis has focused on the failings of the private sector.

And yet, it can be argued that the last two decades of central bank independence has been almost catastrophic for the majority of the populations of the western democracies – particularly the UK and US.

Living standards have fallen as the prices of essential items have risen faster than wages, households have been left with too much leverage and their homes have fallen in value. If that was not bad enough, they now face the threat of a higher tax burden to resolve the fiscal deficit that central bankers and governments have developed.

Compromised position

Given this track record, it seems remarkable that central banks are not under pressure to justify their elevated status within the legislature. But does it even matter? In a post-financial crisis world, with extreme fiscal constraints and lower levels of real economic growth, are central banks really free to pursue independent monetary policy aims? Is this independence only true in theory rather than practice? I would argue that the large fiscal deficits in the US and UK have compromised their central banks almost completely.

The Federal Reserve has a formal mandate “to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates”. But it is clear that Federal Reserve chairman Ben Bernanke has recently chosen to relegate the inflation component of the mandate in priority. The monetary policy stance has been extraordinarily aggressive with QE2 arguably being pre-emptive rather than reactive to a deflationary threat. Is it credible to suppose that the US fiscal deficit plays no part in this policy decision?

Bernanke is well aware that there is no ammo in the fiscal gun – if anything, there will be tightening. Equally, controlling the cost of financing that deficit is important for financial stability (as Italy has discovered). So the Fed effectively became the majority financier of the US debt – a policy driven more by the fiscal situation than monetary policy aims. In short, the Fed has been captured by the government. Is it any surprise that the Fed’s immediate reaction to the recent deficit crisis in Washington was to hint at QE3?

In the UK, the Bank of England appears to have abandoned its mandate altogether. Despite having a pure inflation targeting policy aim, Mervyn King has his focus on growth, stating that “to tighten policy now would risk undesirable volatility in output”. Despite CPI being at least one percentage point above target for the past 18 months and now running at more than double the 2% target, the policy focus is on areas outside of its mandate.

This fairly obvious fact is now widely discussed and even one of the voting members of the rate-setting Monetary Policy Committee, Martin Weale, has seen fit to state that “what an early rate rise would do is reduce the speculation that the bank has departed from its inflation mandate”.

The primary motivation for this appears to be to provide a loose monetary policy environment for the government to pursue their deficit reduction programme. As Willem Buiter, the former MPC member and now Citigroup economist, has said: “The Bank… has overstepped the mark and acted in a very political way.”

The argument to give central banks independence always looked flawed and this is clearly illustrated by the fact that this only works when everything is fine. When it is not, political imperatives take over.
Too much time and effort is being spent maintaining this facade. If central banks are not independent in practice, policymakers should embrace this reality and redefine the policy regime to address the global debt crisis with a co-ordinated fiscal and monetary policy response.